How Does Reinsurance Create Value to an Insurer? A Cost-Benefit Analysis Incorporating Default Risk

Abstract

Abstract:Reinsurance is often empirically hailed as a value-adding risk management strategy which an insurer can utilize to achieve various business objectives.In the context of a distortion-risk-measure-based three-party model incorporating a policyholder, insurer and reinsurer, this article formulates explicitly the optimal insurance-reinsurance strategies from the perspective of the insurer. Our analytic solutions are complemented by intuitive but scientifically rigorous explanations on the marginal cost and benefit considerations underlying the optimal insurance-reinsurance decisions. These cost-benefit discussions not only cast light on the economic motivations for an insurer to engage in insurance with the policyholder and in reinsurance with the reinsurer, but also mathematically formalize the value created by reinsurance with respect to stabilizing the loss portfolio and enlarging the underwriting capacity of an insurer. Our model also allows for the reinsurer's failure to deliver on its promised indemnity when the regulatory capital of the reinsurer is depleted by the reinsured loss. The reduction in the benefits of reinsurance to the insurer as a result of the reinsurer's default is quantified, and its influence on the optimal insurance-reinsurance policies analyzed.

Effect of leverage on income retention of general insurers in East Africa

“…Other downsides of excessive usage of reinsurance and low income retention include counter increased counter party risk (Lo, 2016). This is due to the fact that reinsurers do not have a contractual relationship with the insured and in case they do not pay the share of a claim to the insurance firm, the latter will be completely liable to the insured.…”

“…The cost of reinsurance for Kenyan general insurers averaged 28.37% with a retention ratio of 71.63% for the period of study from 2015 to 2019 (IRA, 2020 2020),the average income retention for the same period from 2015 to 2019 was 55.25% for Uganda, 49.92% for Tanzania and 65.10% for Burundi. Furthermore, studies also indicated other risks associated with overreliance on reinsurance such as credit and liquidity risk (Lo, 2016) and insolvency risk which may force insurers to inject more capital (Mao et al, 2015;Caporale et al, 2017).…”